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4 VALUATION STRATEGIES July/August 20154 VALUATION STRATEGIES
The profit-split method remains an essential tool for valuing intangible
assets when it is refined with case-specific facts and data, including
data that is available from purchase accounting. and
Intangibles
Valuation of
VALUATION STRATEGIES 5July/August 2015 VALUATION STRATEGIES 5
CHRISTOF BINDER AND ANKE NESTLER
Trademarks
Do Not Miss Out On the Advantages of
the Profit-Split Method DespiteUniloc
Based on this asset-specific profit, its
value can be calculated. Despite the
adverse Uniloc decision of the U.S.
Court of Appeals for the Federal Cir-
cuit in 2011,1 profit split is an impor-
tant if not essential element in the
valuation of intangibles. In the wake
of Uniloc, the method needs not only a
vindication, but also a refinement
based on case-specific facts and data.
Purchase accounting data reported in
financial statements can provide both.
Profit-Split In a Nutshell
The profit-split method is one of the
oldest and most frequently applied
methods for the valuation of intangi-
ble assets. Basically, profit-split
attempts to allocate the total profit of
a business to the different assets that
contribute to it, including the subject
intangible. The key element of the prof-
it-split method is the derivation of an
appropriate or reasonable profit-split
percentage based on which a part of
the total profit is apportioned to the
subject intangible.
Overall profit-split Method. Text-
books on IP valuation suggest three
different variants of the method to
arrive at a profit-split percentage.2
According to the overall profit-split
method or contribution profit-split
method, the combined profits earned
by two parties from a transaction (e.g.,
a licensing transaction) are divided
between the two based on some allo-
cation principle.
Analysis of Comparable Businesses.
Under the comparable profit-split
method (CPSM), the profitability of
comparable businesses with compara-
ble IPs is analyzed and applied to the
subject business. Comparable profits
describe the typical profitability of
comparable businesses, including the
full cost or expenses for the IP. The
subject business calculates its prof-
itability before charges for the subject
IP, and then adds an IP charge to arrive
at a comparable profitability.
Residual Profit. The residual profit-
split (RSPM) is a stepwise approach
to profit allocation of different cate-
gories of assets. It starts with routine
contributions to assets that are easy to
value, i.e. tangibles or intangibles with
a typical return rate. Thereafter, the
residual profit is allocated to the
remaining “special” IP assets of the
subject business.
Complications. These three methods
may sound simple, but in practice they
are much more complicated. First,
availability of data is limited. It is hard
to find financial reporting data for
comparable businesses with compara-
ble IP, let alone accounting data about
their IP. Further, there are no typical
return rates for different classes of
assets, at most for typical ranges of
such return rates. Another restriction
of the method is that it is a typical
chicken-and-egg phenomenon. The
concept of dividing profits among
assets is both the crux of the problem
and its solution. If the value of the dif-
ferent assets and IPs was known, a
profit allocation would not be need-
ed. And if the profit-split to different
assets was known, it would be easy to
calculate their values. But it is an equa-
tion with two unknown variables. So,
valuing IP by comparables or by resid-
uals—as the profit-split method sug-
gests—is easier said than done.
Having said that, how can it be
explained that the profit-split method
is one of the most frequently applied
methods to value IP? Well, this is
because valuation practice found two
ways out of this dilemma. One is sim-
plification, the other sophistication.
Simplification. The problem of non-
availability of data was circumvented
by simplification, or the so-called rules
of thumb. As case-specific profit-split
data was not available, valuation prac-
tice came up with some universal per-
centage figures presumed to be typical
or average profit-split ratios for intan-
6 VALUATION STRATEGIES July/August 2015 PROFIT-SPLIT METHOD
CHRISTOF BINDER, PhD, MBA, is an expert in trademark transactions, licensing, and valuation. He is CEO of
Trademark Comparables AG in Switzerland, and MARKABLES, an online database providing comparable data from
over 6,500 published purchase valuations of business combinations with a particular focus on trademarks. ANKE
NESTLER PhD, MBA, CVA, CLP, is owner of Valnes GmbH, an independent valuation boutique based in Frank-
furt, Germany, specializing in the valuation of companies and intangible assets. Prior to establishing Valnes, she was
with PricewaterhouseCoopers and Oppenhoff Radler Corporate Finance. Her expertise includes M&A, asset con-
tributions, squeeze-outs, tax disputes, arbitration, and succession and legacy issues.
A profit-split analysis for a trade-
mark or other intangible asset
attempts to quantify what share
of the profit of a business is
attributable to the subject asset.
gibles. In its early version, the rule of
thumb said that 25% of the profit of a
business is attributable to its IP. Dur-
ing the course of time, the rule was
extended to different ranges extending
from 10% to 35%. Further, the profit-
split method was often downgraded
to a secondary method used to cor-
roborate or “sanity check” the results
of other primary valuation methods.
The good thing with this simplification
was that—once the percentage range
was commonly accepted—its results
were easy to comprehend for unin-
volved recipients like auditors, judges,
or bankers.
More Sophisticated. On the other
hand, the profit-split method became
much more sophisticated through finan-
cial modeling. Financial modeling is a
tool to solve a valuation problem with
different unknown variables and differ-
ent assets to be valued within one and the
same model.Typically,such models have
some fixed limitations,for example enter-
prise value, total profit, and WACC. The
model simulates—within such limits—
the unknown variables such that the out-
come is most plausible. As a
mathematical method, financial model-
ing is some sort of dynamic program-
ming,where different parts of a problem
(subproblems) are solved independent-
ly and then combined to reach an over-
all solution. Computer software greatly
fostered the diffusion of financial mod-
eling in valuation. However, its com-
plexity results in reduced transparency;
uninvolved recipients have problems to
fully comprehend the results of such val-
uations. Therefore, financial modeling
is the preferred method for internal use.
Profit-Split—
From its Origins to Uniloc
The profit-split method was pioneered
50 years ago by Robert Goldscheider,
one of the early masterminds in tech-
nology transfer.3 At the time, Gold-
scheider worked as special counsel in
technology transfer and licensing issues
for Philco Corporation, a consumer
electronics company based in Philadel-
phia. Outside North America, Philco
sold its products in 18 countries
through licensing arrangements with
local companies. The license agree-
ments included various product tech-
nologies and patents, trade secrets and
know-how, and a set of marketing
intangibles including trademarks, pho-
tos, drawings, and other copyrighted
materials. Further, Philco supplied key
components under favorable terms to
its licensees. For this bundle of IP and
supply rights, each licensee paid a roy-
alty rate of 5%. All licensees operated
successfully in their local markets.
After guiding the business and
working with the licensees for two
years, Mr. Goldscheider observed that
VALUATION STRATEGIES 7PROFIT-SPLIT METHOD July/August 2015
1 Uniloc USA, Inc. v. Microsoft Corp., 632 F.3d
1292 (CA-F.C., 2011).
2 Smith and Parr, Valuation of Intellectual Property
and Intangible Assets, 3rd ed. (John Wiley &
Sons, 2000) pages 401-403; Llinares and Mert-
Beydilli, “How to Determine Trade Marks
Royalties,” 32 International Tax Review 12
(December 2006) pages 29-30; Zyla, Fair Value
Measurement: Practical Guidance and
Implementation, 2nd ed. (John Wiley & Sons,
2012), pages 288-293; Reilly and Schweihs,
Guide to Intangible Asset Valuation (AICPA, 2013)
pages 311-312.
3 For a detailed description see Goldscheider, “The
Classic 25% Rule and The Art of Intellectual
Property Licensing,” 46 Les Nouvelles 148
(September 2011), pages 151-153.
the pre-tax profitability of each
licensee was approximately 20%. Mr.
Goldscheider concluded that “5 per-
cent was a healthy royalty rate, and I
was interested to note that it usually
constituted about 25 percent of the
profitability ultimately achieved by the
various licensees.” This finding was
the starting point for Goldscheider to
investigate the influence of actual or
potential profitability of licensing
transactions on the setting of royalty
rates. He observed similar patterns
from later technology transfer and
licensing arrangements. A revenue
treatment ratio of 3:1 between the
licensee’s and the licensor’s interests
proved to be workable in a number of
different transactions in unrelated
industries.
These early empirical observations
led toward the formulation of a prag-
matic 25:75 baseline working method-
ology which generated businesslike
results in the negotiation of license
agreements, and were the starting point
of the profit-split method. The 25%
(or any other percentage resulting from
a particular royalty rate) is the part of
the profit of a business which relates to
the IP used by it.
Refinement. Later, the method was
refined by the “next best alternative”
available to the licensee. Starting from
the baseline 25% ratio, a serious
licensee would also consider the cost of
the next best available alternative (e.g.,
development of the IP in-house, licens-
ing other comparable IP, etc.) and com-
pare it to the cost (royalty rate) at the
25% baseline profit-split ratio, even-
tually resulting in a lower or higher
profit-split. Over time, the empirical
25% ratio of the early days was extend-
ed to a range from 10% to 35%, based
on either net or gross profits, howev-
er with its center point always remain-
ing at 25%.
In the course of time, the method
was frequently applied by valuation
professionals in various situations for
its simplicity, for example:
• For the negotiation of royalty rates
in IP licensing.
• By many courts to corroborate the
determination of reasonable roy-
alty rates to compensate for IP
infringements.
• In transfer pricing to check the
remaining profitability of a busi-
ness after applying arm’s-length
royalty rates for the licensed IP.
• In financial valuations of IP to
cross-check the feasibility of mar-
ket comparables with business
profitability.
• In accounting and auditing for
quick checks of IP on the balance
sheet.
Uniloc. In 2011, the U.S. Court of
Appeals for the Federal Circuit brought
an abrupt termination to the applica-
tion of the 25% profit-split rule of
thumb. In its ruling in a patent
infringement dispute between Uniloc
and Microsoft, it held that:
the 25 percent rule of thumb is a
fundamentally flawed tool for
determining a baseline royalty rate
in a hypothetical negotiation. Evi-
dence relying on the 25 percent
rule of thumb is thus inadmissible
under Daubert and the Federal
Rules of Evidence, because it fails
to tie a reasonable royalty base to
the facts of the case at issue.4
The Court of Appeals further
explained that this rejection is not
meant to be a limit to general valuation
principles, but only to the application
of flat-rate schemes.
This court’s rejection of the 25 per-
cent rule of thumb is not intended
to limit the application of any of
the Georgia-Pacific factors. In par-
ticular, factors 1 and 2—looking
at royalties paid or received in
licenses for the patent in suit or in
comparable licenses—and factor
12—looking at the portion of prof-
it that may be customarily allowed
in the particular business for the
use of the invention or similar
inventions—remain valid and
important factors in the determi-
nation of a reasonable royalty rate.
However, evidence purporting to
apply to these, and any other fac-
tors, must be tied to the relevant
facts and circumstances of the par-
ticular case at issue and the hypo-
thetical negotiations that would
have taken place in light of those
facts and circumstances at the rel-
evant time.
The rejection of the 25% rule of
thumb underscores the importance of
using facts of a particular case in cal-
culating the reasonable value of IP.
Having been widely accepted prior to
this court decision, the 25% rule’s
rejection is felt across the valuation
profession in all different applications
of the profit-split method. Valuators
are now expected to provide compa-
rable profit-split data for their subject
case, which almost always does not
exist, and the lack of which was one of
the reasons to apply the simple but
comprehensive “rule of thumb” per-
centage ranges.
The Limitations of the
Classic Profit-Split Method
Irrespective of the specific reasons that
led to the rejection of the 25% rule in
the Uniloc case, there are—and always
have been—a number of conceptual
limitations to the classic profit-split
method:
1. Bundle of rights. The license agree-
ments in the original Philco exam-
ple comprised a bundle of different
IP rights, including patents,
knowhow, trademarks, copyrights,
and sourcing rights, at a royalty rate
of 5% and a profitability of 20%.
Each IP individually would have
had a lower royalty rate, and a low-
er profit-split ratio. Thus, the actu-
al profit-split ratio depends on the
scope of the licensed rights.
2. No market price. According to the
principles of the profit-split
method, the licensed IP does not
have a typical market price. Its price
(royalty rate) is determined by the
cost and revenue structure of the
licensee and the resulting prof-
itability, but not by the price that
other licensees might have paid for
similar IP, or that the licensor had
achieved for similar IP in previous
8 VALUATION STRATEGIES July/August 2015 PROFIT-SPLIT METHOD
licensing negotiations. In reality
however, the price for IP is some-
times what the licensor asks for—
irrespective of the profitability of
the licensee.
3. No actual profits. The negotiation of
royalty rates—and the resulting
sharing of profits—is based on prof-
it expectations of the licensee, but
not on actual profits which might
differ from expectations. Often, a
license agreement relates to the sub-
sequent launch of a new product or
business. Depending on the source
and the definition of failure, the flop
rate of new product launches is
between 40% and 80%. Obviously,
actual profitability often does not
match original expectations. Ex-
post, it is likely that numerous
unsuccessful licenses were overpaid
with excessively high royalty rates.
4. No stable profits. Typically, the
launch of a new (licensed) business
requires some initial investment and
expenses in the early stage. Average
profitability varies from the start of
a licensed business until the end of
its contract term. Thus, the licensee
has to consider average expected
profitability over the term of the
agreement when negotiating the
royalty rate.
5. Profit and benefit base. There has
always been some degree of dis-
agreement on the profit base for the
profit-split method. The suggested
profit base ranges from fully loaded
profit (net profit) over gross profit
to marginal or incremental profit.
The benefits of a license may be
attributed to the products sold that
incorporate the IP, or to components
or manufacturing processes only.
6. International expansion. The ori-
gins of the profit-split method—as
described by Robert Goldschei-
der—go back to international
licensing in an age of import restric-
tions, tariffs, and entry barriers. For
a company to expand internation-
ally there was often no alternative to
licensing. The licensed property was
granted on an exclusive basis in the
licensed territory. Today, licensing is
often an approach within the same
territory, for example via non-exclu-
sive patents or brand extensions. It
is not clear how this shift affects
profitability and profit-split.
7. Value of IP increasing. As is wide-
ly known, intangibles make up for
an increasing share of enterprise
value. Today, intangibles account
for an average of 80% of enterprise
value while 50 years ago this per-
centage was in the area of 25%. In
parallel with the structure of assets
and value drivers, the sources of
profit changed over time. Profits
generated by intangibles increased
at the same rate. Today, 80% of
profits5 come from intangibles. At
the origin of the profit-split con-
cept, the 25% of profits generated
by IP were allocated to IP. Today,
the 25% profit-split rule allows only
a fraction of IP-related profits to
be allocated to IP.
Maybe these—and other—incon-
sistencies have been the reason for the
extension of the classic profit-split con-
cept from the initial 25% ratio to a
larger range from 10% to 35%. But the
major source of criticism of the prof-
VALUATION STRATEGIES 9PROFIT-SPLIT METHOD July/August 2015
4 Uniloc, note 1, supra, page1055.
The method needs not
only a vindication, but
also a refinement.
it-split method has always been its
missing empirical evidence. The
method has never been proven and
confirmed—except by Robert Gold-
scheider’s description of the Philco
case and the fact that it was widely
used and accepted.
Empirical History
There have been a few attempts to pro-
vide empirical evidence for the gener-
al validity of the classic profit-split
rule. The first attempt was made by
Robert Goldscheider himself in 2002 to
rebut the often stated criticism.6 Gold-
scheider and his co-authors tried to
compare royalty rates from thousands
of actual licensing transactions with
expected long-run profit margins of
the products that embody the subject
IP. However they admit right away that
they were unable to undertake a direct
comparison of product profit and roy-
alty rates because they had no access to
such data.
In a first step, Goldscheider et al.
selected 1,533 license agreements with
running royalty rates on sales, grouped
them into 15 industries, and identified
median royalty rates per industry. In a
second step, they identified 347
licensees from the 1,533 agreements
that report and disclose their financial
statements. Taking the total operating
income of these companies, the authors
compute an average operating profit
margin for the 15 industries over a
period of 10 years. Then, they com-
pare the 15 median industry royalty
rates with the 15 average profit margins
and find an average ratio of 27%.7 They
conclude that the empirical analysis
provides “some support” for the use of
the 25% profit-split rule, but they also
admit “that there is quite a variation in
results for specific industries,” ranging
from an 8.5% split for the semicon-
ductor industry to an 80% split in the
automotive industry (see Exhibit 1).8
Likely, these variations would be even
larger at the level of the 347 individual
companies. The empirical test shows
that on average the 25% split ratio is a
good overall approximation, but the
statistical variance is too high to
explain the split ratios at an industry
let alone company or licensed business
level.
Second Study. A second attempt to
analyze the relation between prof-
itability and royalty rates was pub-
lished by Kemmerer and Lu in 2008.9
They used average industry royalty
rates for 14 industries compiled from
3,015 license agreements, and prof-
itability from a fully separate sample of
3,887 companies mapped into the same
14 industries.As profitability measures
they test operating profit, EBIT, and
gross profit. Interestingly, the average
royalty rate in their sample is 7.0%,
which is substantially higher than the
median rate of only 4.3% observed by
Goldscheider et al. On average they
find that royalty rates account for 15%
of gross, 41% of EBITDA, and 53% of
EBIT margins. They confirm earlier
findings that these overall ratios vary
at industry level. Finally, they provide
some limited support for the validity of
the 25% rule based on operating prof-
its assuming a (hypothetical) forced
linear fitting between royalty rates and
operating margins.
In a specification of his first study,
Lu conducted a pro forma analysis
based on corrected “pre-royalty” prof-
itability data.10 In other words, he
added the royalty rate on top of the
profit margin, thereby assuming that
the licensee considers the profitabil-
ity of the licensed business before pay-
ing royalties for the IP and then
applies the profit-split on this (high-
er) margin. Lu now finds an average
13% profit-split based on gross prof-
it, 26% on EBITDA and 32% on EBIT.
Based on these results, Lu concludes
“The 25% rule still rules” and sug-
gests starting royalty negotiations with
25% of EBITDA margin or 33% of
EBIT margin. What he does not say
10 VALUATION STRATEGIES July/August 2015 PROFIT-SPLIT METHOD
EXHIBIT 1
Profit-Split by Industry
Source: Goldscheider, Jarosz, Mulhern 2002
automotive
chemicals
computers
consumer goods
electronics
energyfood
internet
machine, tools
pharma, biotech
semiconductors
software
telecom
0%
5%
10%
15%
20%
25%
30%
35%
2% 3% 4% 5% 6% 7% 8%
avgoperatingprofitmargin
mean royalty rate
IP Profit Split by Industries - Goldscheider Study 2002
50% split line
25% split line
15% split line
healthcare
however is that on this pre-royalty
assumption Goldscheider’s classic rule
would transform from 25% down to
20%.11 Moreover, he does not address
the large bandwidth of the individual
or industry value around the overall
average.
Evidence Not Provided. None of the
empirical tests could provide evidence
for the validity of the 25% rule.12 The
difficulty with these studies is that it
was not possible to analyze the royal-
ty rate and the profitability of a
licensed business from the same set
of data. Typically, researchers ana-
lyzed a set of royalty rates, and a sep-
arate set of profit rates of other busi-
nesses in the same industry. There is
some evidence that the overall average
profit-split might well be in the area
of 25%, depending on the profit base
used. However, the variance from that
average can be very large at the level
of individual cases, thus the average
being eventually meaningless in a spe-
cific case. The rule might still be used
as some sort of a rule if the frequen-
cy distribution of the individual val-
ues around the mean value was
known. This not being the case, the
rule is not a rule but an average val-
ue with little relevance for a subject
case. Insofar, the Court of Appeals
was correct to require the considera-
tion of relevant facts and circum-
stances of the case at issue.
Does Profit Explain
IP Value At All?
Very broadly speaking, valuation is
strongly oriented towards market
prices or other concepts that come
close to it. If market prices do not exist
for an asset—which is typical for any
IP asset—the next best principles are
fair value or arm’s-length. Both prin-
ciples try to reconstruct a hypotheti-
cal but realistic transaction between
unrelated parties.
Now, how does profit-split fit into
these principles? According to profit-
split, the price of an IP asset depends
on the profitability of the business
that uses this IP. If the profitability of
the business is low, a hypothetical
independent buyer would pay a low
price for it, and vice versa. However in
reality, the value of the IP for the buy-
er might depend less on the prof-
itability of the seller than on the
benefit of the IP for the buyer. This
raises the question if the value of IP
depends on business profitability, and
if this is a discrepancy between prof-
it-split and other valuation methods
which are based on market transac-
tions? Interestingly, the valuation pro-
fession never discussed the question
if there is a significant causality
between business profitability and IP
value. A clear yes to this question is
however a prerequisite for the future
application of the profit-split
method—at whatever percentage
ratio. To have a closer look at this
question, we have to change perspec-
tive. The question to ask is not if prof-
itability explains the value of IP, but
rather, if IP contributes to profitabil-
ity, and if, so how much?
Tangible Assets. If we looked for a
moment at tangible assets only—
PP&E, inventory, receivables—they are
not profitable as such. The business
must generate enough profit to pay for
their depreciation. If the business want-
ed to sell them, it would typically earn
their book value, without making a
profit or a loss. If it is able to make
profit on tangible assets, it is either
because of speculation or these assets
are currently in short supply. Thus, all
tangibles sitting on the balance sheet
generate the profit they have to: their
depreciation and/or their cost of
finance. Let us call this the base prof-
it on book value.
VALUATION STRATEGIES 11PROFIT-SPLIT METHOD July/August 2015
5 Or more, depending on the required return rates
on tangibles and intangibles.
6 Goldscheider, Jarosz, and Mulhern, “Use Of The
25 Per Cent Rule in Valuing IP,” 37 Les Nouvelles
123 (December 2002).
7 Using data from successful licensees only.
8 This range does not include the media and enter-
tainment and the internet industry. Here, long-
term industry profitability is far below median
royalty rates, resulting in flawed ratios.
9 Kemmerer and Lu, “Profitability and Royalty
Rates Across Industries: Some Preliminary
Evidence,” 8 J. of the Academy of Business and
Economics (March 2008).
10 Lu, “The 25% Rule Still Rules—New Evidence
from Pro Forma Analysis in Royalty Rates,” 46
Les Nouvelles (March 2011).
Valuators are expected to
provide comparable data which
almost always does not exist.
Unaccounted Intangibles. Any addi-
tional profit on top of such base prof-
it would be for assets that are not yet
on the balance sheet—(unaccounted)
intangibles. The value of these intan-
gible assets would be the higher the
more profitable the business. This is a
very simple logic. The only difficulty is
that we can’t see the value of these
intangibles in the books. They are not
accounted for—unless the business is
acquired.
A next question is—what would
happen if the profitability and the
value of the business increased? From
which “improved” assets would the
increased profitability come from? To
understand these connections better,
we have a closer look at the consec-
utive purchase accounting of two
companies that were acquired two
times within a few years, and analyze
how different assets developed (see
Exhibit 2).13
Both cases are quite different in
their valuation multiples. EPAX has a
high valuation in a high-margin and
growth business; Cellu is a commod-
ity business with low margins and
large machinery. In both cases, the
first acquirer created significant val-
ue before he resold the company. Vis-
ibly, both invested massively in
tangible assets, thereby restructuring
the business and increasing capacity,
revenues and margins. But enterprise
value grew by much more than only
by these visible and accountable
investments in tangibles. Intangible
assets increased as well. Higher qual-
ity, more efficient processes, and
increased expenses for R&D and mar-
keting might all have contributed to
the increase in intangibles. Whatever
it was, the two examples show that
higher profitability typically results
in higher valued intangibles.
Data Availability. Data availability is
limited for such time-series analysis.
Only a few such cases are known and
reported in sufficient details. Howev-
er, single values can be analyzed in
large data samples from purchase
accounting databases, like MARK-
ABLES.14 Linear regression analysis
illustrates how the asset structure of
businesses changes with increasing
profitability. The share of tangibles
assets within enterprise value decreas-
es with increasing profitability, while
the share of goodwill increases. Iden-
tifiable and separable intangible assets
behave steadily, as illustrated in Exhib-
it 3.15
The flat line for intangibles shows
that the value of intangibles behaves
proportionately with profitability. In
other words—if profitability doubles,
the value of intangibles will—on aver-
age—also double. Of course—this rela-
tion might be different for a particular
business. But as an overall relation-
ship, there is causality between prof-
itability and the value of intangibles.
This may sound simple and clear-cut,
but it is an important if not vital find-
ing for the future of the profit-split
method. If this causality did not exist,
profit-split would be doomed to die,
not only as a 25% flat rule, but alto-
gether.
Applying Profit-Split Based on
Purchase Accounting Data
As stated earlier, one major problem
of the classic profit-split method is
data availability. Except for the few
Philco licensees cited by Robert Gold-
scheider, profit-split could never be
tested from a concise set of data. It
was simply not possible to observe
the value of the IP (its royalty rate)
and the profit for the same IP, because
either one of the two was unknown.
A license agreement shows a royalty
rate, but not the profitability of the
12 VALUATION STRATEGIES July/August 2015 PROFIT-SPLIT METHOD
11 25/100 versus 25/(100+25).
12 A detailed discussion of the empirical tests was
published by Kidder and O’Brien, “Simply Wrong:
The 25% Rule Examined,” 46 Les Nouvelles 263
(December 2011).
13 Norwegian EPAX AS, a supplier of Omega-3 fish
oils, was acquired in 2007 by Austevoll Seafood
ASA, and then in 2013 by FMC Corporation. Cellu
Tissu is a manufacturer of specialty tissue paper
for use in personal hygiene products. Cellu Tissu
was acquired in 2006 by Weston Presidio (an
investment firm), and in 2010 by Clearwater
Paper.
14 MARKABLES is a database containing data from
over 6,500 PPAs, with a particular focus on trade-
mark and brand assets. www.markables.net
15 The three lines add up to more than 100% due
to non-interest-bearing liabilities. Such liabilities
decrease with increasing profitability.
Meaningful profit-split
data is available from
purchase accounting.
licensed business, even not its expect-
ed profitability. Even more, a licensee
would be ill-advised to reveal his
profit expectations to the licensor
during license negotiations. And years
later, the profit and loss statement of
a licensed business no longer tells
what royalty rate the licensee would
have accepted, had he known its lat-
er profitability.
Data from Purchase Accounting.
However, meaningful profit-split data
is available in substantial numbers
and detail from purchase account-
ing. Possibly, our view was clouded
due to the approach of splitting prof-
it between two separate parties we
became so much used to. Purchase
accounting, which is also frequently
referred to as acquisition account-
ing, is the process of classifying, valu-
ing, and accounting for all of the
assets and liabilities that are includ-
ed in the acquisition of a business.
This process is rather standard for
the tangibles assets and the liabili-
ties that are already in the books of
the acquired business. The difference
between the book value of the
acquired assets and liabilities and the
purchase consideration is then allo-
cated to the various intangible assets,
and to goodwill.
Technically, the purchase consider-
ation paid for the acquired business
(or the enterprise value including debt)
is the present value of all returns it is
expected to generate in the future. The
valuation of the intangible assets is an
allocation of these expected future
returns to particular assets. And the
present value of any intangible asset
at the date of the acquisition relates to
its share of total future returns that are
expected from that business. This reads
like the nearly perfect profit-split for
intangibles, and in fact it comes close
to it. The results from purchase
accounting— purchase price alloca-
tions on business combinations—are
reported manifold in the financial
statements of public companies. Exhib-
it 4 illustrates how to compute profit-
split data from the results of a purchase
price allocation. In this particular busi-
ness, 38% of future profits are expect-
ed to come from (existing) customer
relations, 17% from product technol-
ogy and 4% from trade names.
VALUATION STRATEGIES 13PROFIT-SPLIT METHOD July/August 2015
EXHIBIT 2
Asset Development over Time
Source: MARKABLES.net
Development of Assets Over Time – Purchase Accounting
EPAX AS Cellu Tissu Holdings, Inc.
US$ million 2007 2013 2006 2010
revenues 40 75 1.9x 329 511 1.6x
enterprise value 98 340 3.5x 208 534 2.0x
sales multiple 2.5x 4.5x 1.9x 0.6x 1.0x 1.7x
tangible assets 40 212 5.2x 143 406 2.8x
intangible assets 91 215 2.4x 70 286 4.1x
debt 42 0 - 163 287 1.8x
EXHIBIT 3
Value of Identifiable Intangible Assets
4,550 share deals between 2004 and 2014
Source: markables.net
profitability
enterprise value/revenues
0%
20%
40%
60%
80%
100%
0x 1x 2x 3x 4x 5x 6x 7x 8x 9x 10x
percentofenterprisevalue
tangibles intangibles goodwill
y = -0,0532x + 0,972
y = 0,0133x + 0,4608
y = -0,0025x + 0,3816
Profitability and Asset Value
Linear Regressions
These data applied to the more clas-
sic profit-split methods mean that Life
Technologies would be willing to pay
21.6% of his profits as a royalty to
license-in product technology, trade-
marks and in-process research.16
Moreover, Life Technologies would
likely not pay a royalty for customer
relations because these are typically
owned and cannot be licensed-in.
The use of such data is compellingly
convincing. Still, the following limita-
tions should be noted:
1. Useful life. Intangibles assets have
different useful lives. For an intan-
gible asset with a short useful life, its
profits are expected to be generat-
ed faster, and vice versa for an intan-
gible asset with very long or
indefinite life. A 10% profit-split
with a useful life of ten years means
a higher profit margin (for the next
ten years) than a 10% profit-split
over 20 years.
2. Fair value. The value of an intangi-
ble asset as stated in the purchase
price allocation (PPA) is its fair val-
ue, not its market value or market
price.17 It is thus the result of a fair
value calculation. Still, it comes
close to the willingness of the
acquirer to pay for this particular
asset, based on a real transaction of
ownership of the subject business in
total. Based on this real transaction,
the fair values for particular intan-
gibles can serve as a meaningful
approximation for “market” prices
paid for such intangibles.
3. Different use. The data represents
the view of the acquirer, not the pre-
vious owner. If the acquirer intends
to restructure the business, or if he
has only little use for a particular
14 VALUATION STRATEGIES July/August 2015 PROFIT-SPLIT METHOD
EXHIBIT 5
Profit-Split Analysis
0
50
100
150
200
250
300
350
2.5%
7.5%
12.5%
17.5%
22.5%
27.5%
32.5%
37.5%
42.5%
47.5%
52.5%
57.5%
62.5%
67.5%
72.5%
77.5%
82.5%
87.5%
92.5%
97.5%
occurence
% of enterprise value
Profit Split of Licensable Intangibles in % of enterprise value
25% quartile 9.0%
median 18.2%
75% quartile 32.1%
mean 24.4%
4,550 share deals between 2004 and 2014; identifiable intangible assets not including customer relations
Source: markables.net
75 quartile
25 quartile
median
EXHIBIT 4
Computation of Profit-Split Data
Useful life
(years)
Life
Technologies(In millions)
Purchase Price
Net Assets Acquired
Cash paid $ 13,487.3
2,279.5
7,167.0
$ 15,303.8
2,626.9
5,883.0 16
748.1
619.1
246.7
58.4
$ 15,303.8
$ 1,755.5
(463.0)
(3,800.9)
Current assets
Property, plant and equipment
Definite-lived intangible assets:
Indefinite-lived intangible assets:
Goodwill
Other assets
Liabilities assumed
Customer relationships
Product technology
Trade names and other
In-process research and development
Debt assumed
Cash acquired
11
9
Profit split
100.0%
38.4%
17.2%
4.0%
0.4%
46.8%
Acquisition of Life Technologies Corp. by Thermo Fisher Scientific Inc.
Purchase Price Allocation as of February 3, 2014
Source: Thermo Fisher Scientific Inc., Form 10-K for the Period Ending 12/31/2014;
profit split calculation by authors
intangible, he might allocate only
little value to it, while this particu-
lar asset had a higher value to the
previous owner, and vice versa.
4. Liabilities involved. In the PPA illus-
trated in Exhibit 4, the acquisition
was a share deal involving non-
interest-bearing liabilities of $3.8
billion. These interest-free liabili-
ties reduce the 100% base. Or, there
are assets in the same amount that
do not need to generate returns.
Often, this is covered by netting of
short-term working capital. If the
acquisition is however performed
as an asset deal, these liabilities are
often not part of it, and the 100%
base is higher. In such cases, prof-
it-split data taken from asset deals
must be adjusted by liabilities that
are typical for the subject industry.
5. Tax. The value of intangibles and
goodwill can vary for its tax
deductibility. Tax deductibility
results in a higher value and in an
interest-free tax liability of the same
amount, and thus in a higher prof-
it-split percentage. Typically, this
information can be found with the
PPA. In the case illustrated in Exhib-
it 4, neither intangibles nor goodwill
are deductible for tax purposes.
Benefits. On the other hand, the ben-
efits of profit-split based on purchase
accounting data are quite obvious:
1. Data availability. Numerous data are
available in the public domain and
fully open to scrutiny.
2. Data quality. Data are calculated
according to national and interna-
tional accounting standards. More-
over, results of valuations are
cross-checked relative to each oth-
er and against the 100% threshold
of purchase consideration effectively
paid. Finally, data are audited by
CPAs.
3. Transaction-based. Data result from
real market transactions on M&A
markets, where market conditions
are more“perfect” than on licensing
markets. Prices paid are based on
commonly accepted valuation mul-
tiples and on thorough due dili-
gence.
4. Established businesses. Businesses
covered are fully established and
reliably assessable. This compares
to licensed businesses which are
new and risky at the effective date
of the license agreement, and often
fail to succeed.
5. Profits from long-term ownership.
Profitability is based on expected
long-term, fully loaded profits to
acquire and own the intangible. This
is a more realistic concept than
profit under a rather short-term
license agreement.
6. Integrated data. Last but not least,
the method is based on integrated
data. Both price (value) of intangi-
bles and profit-split relate to one
and the same business.
A Reconciliation of the
Classic Profit-Split Method
Using data from purchase accounting
as comparables for profit-split valua-
tion is a new approach. Now, it would
be interesting to see how such data
compare to the earlier attempts to ver-
ify the validity of the classic profit-
split method. The following analysis
is based on data taken from the
MARKABLES database.18 The profit-
split for the sum of licensable intangi-
bles was analyzed as percent of
enterprise value. Licensable intangi-
bles were defined as identifiable intan-
gibles not including such intangibles
that are typically not licensable (e.g.,
customer relations, customer contracts,
or backlog). The findings are illus-
trated in Exhibit 5.
VALUATION STRATEGIES 15PROFIT-SPLIT METHOD July/August 2015
16 17.2% + 4.0% + 0.4%.
17 For a comprehensive and detailed overview of
fair value accounting, see Zyla, note 2, supra.
18 The MARKABLES database contains data from
over 6,500 PPAs, with a particular focus on trade-
mark and brand assets (www.markables.net).
Business reality is far too
diverse to be mapped with
averages or narrow ranges.
Support for Goldscheider. Interest-
ingly, the findings provide strong evi-
dence for Robert Goldscheider’s early
observations. The mean profit-split of
licensable intangibles is 24.4%, thus
very close to Goldscheider’s 25%
observation. This finding is good for
both Goldscheider, whose classic rule
receives some sort of reconciliation,
and for the purchase accounting-based
method which shows mean values very
similar to those found in the earlier
research performed by Goldscheider
et al. It must be noted that these find-
ings relate to the sum of all (hypo-
thetically) licensable intangibles a
company owns or uses.
But beyond that 25% mean value,
the findings also show the large band-
width of individual data. 50% of all
cases are situated somewhere between
a 9% and a 32% profit-split. The oth-
er 50% of the cases have profit ratios
even below or above these percentages.
Obviously, there exist many business-
es that need very little if any licens-
able intangibles to operate, and there
are others whose value structure is dri-
ven to a very large extent by such
intangibles. This is exactly what the
Court of Appeals found and ruled in
the Uniloc decision. Business reality is
far too diverse to be mapped with aver-
ages or narrow ranges.
Trademark Profit-Split
profit-split in the original Philco analy-
sis—and in many cases thereafter—
was based on a bundle of different IP
rights, including patents, know-how;
trade names, and copyrights. This
bundling seems to be usual practice
in IP licensing. Out of 13,078 license
agreements with unredacted running
royalty rates listed in the RoyaltySource
database, 83% comprise bundles of
various IP rights, and no more than
13% are pure play license agreements
covering one specific IP only.19 How-
ever, IP valuation and litigation is often
about one particular IP; the bundle is
more typical in transfer pricing for
subsidiaries. The following discussion
takes a closer look at the valuation of
one particular intangible asset, name-
ly trademarks (or brands).
Exhibit 6 illustrates the frequency
distribution of trademark profit-split
which—being a part of the total licens-
able asset bundle—must necessarily
be lower (further left) than the distri-
bution for all intangibles in Exhibit 5.
The analysis shows that trademarks
(or brands) account for an average of
13.1% of enterprise value or future
profits. The median of the distribution
is 6.6%.With regard to the classic prof-
it-split rule of 25%, this would be far
too high to be applied as a rule of
thumb on a pure play trademark alone.
Again, the bandwidth over all different
trademarks in the sample is very high,
ranging from close to zero up to over
100%.20
It is immediately clear that a brand
of Swiss luxury watches must make a
much higher contribution to profit
than the trade name of an oil well
drilling business in Idaho. Or in the
case of a natural cat litter business, the
value of the brand accounts for near-
ly 100% of enterprise value; the busi-
ness sources the packaged products
from a quarry mill nearby; it has no
own production or technology, and no
relations to end customers. Almost all
of its enterprise value is driven by the
brand. As the Court of Appeals con-
cluded in Uniloc,“evidence … must be
16 VALUATION STRATEGIES July/August 2015 PROFIT-SPLIT METHOD
EXHIBIT 7
Trademark Profit-Split Analysis of Watch Businesses
0% 5% 10% 15% 20% 25%
- trademark profit split and royalty rates -
0%
20%
40%
60%
80%
100%
120%
1 2 3 4 5 6 7 8 9 10 11
Watch businesses Watch businesses
- trademark profit split (% of enterprise value) -
luxury watches
commercial watches
distressed
businesses
Source: markables.net
R = 0.85112
75 %ile25 %ile median
EXHIBIT 6
Frequency Distribution of Trademark Profit-Split
0
50
100
150
200
250
300
350
400
450
1%
3%
5%
7%
9%
11%
13%
15%
17%
19%
21%
23%
25%
27%
29%
31%
33%
35%
37%
39%
Trademark Profit Split in % of enterprise value
0
50
100
150
200
250
300
350
400
450
1%
3%
5%
7%
9%
11%
13%
15%
17%
19%
21%
23%
25%
27%
29%
31%
33%
35%
37%
39%
occurence
% of enterprise value
25% quartile
median
75% quartile
mean
4,550 share deals between 2004 and 2014
Source: markables.net
75 quartile
25 quartile
median
2.5%
6.6%
16.5%
13.1%
tied to the relevant facts and circum-
stances of the particular case at issue.”
To further illustrate this, a peer
group analysis of trademark profit-
split in the watch-making business
based on purchase accounting data was
performed (see Exhibit 7).Watches are
generally known to be highly brand
driven and to generate attractive prof-
it margins. The peer group includes
eleven different watch brands of which
six are based in Switzerland, four in
the U.S., and one in Germany.
Obviously, the profit-split ratios for
the eleven watch businesses show a
wide range from 18% to 102% (Exhib-
it 7, left part). The 25-75 quartiles
range from 22% to 60%, the median is
25%. Towards the high end of the dis-
tribution, the curve shows a steep
increase. This particular peer group—
as any other peer group—illustrates
that industry or category specific prof-
it-split ratios do not exist. Too differ-
ent are the value driver and
profitability structures at a company
level, even within the same industry.
Further analysis reveals however a
linear relation between trademark
profit-split and royalty rates (Exhib-
it 7, right part). The higher the prof-
it-split ratio, the higher the royalty
rate which the trademark generates
on revenues. When looking closer at
the eleven watch businesses, a clear
segmentation appears. Luxury watch-
es during normal course of business
show both high profit-split ratios and
high royalty rates. Commercial or
fashion watches show medium roy-
alty rates and profit-split ratios. The
third segment comprises watch busi-
nesses in a turnaround situation.
Considering the retail prices of the
watches in that segment, they belong
to the premium/luxury segment; con-
sidering their weak profitability how-
ever, their accounts leave no room for
high trademark values. Thus, trade-
mark profit-split becomes a major
determinant of trademark value in
connection with other determinants
like royalty rate and overall profit
margins. Similar trademark analyses
can be performed for most categories
or industries.
Transfer Pricing Application. The
application of such profit-split analy-
ses is not limited to the valuation of
intangible assets; it is also helpful in
transfer pricing issues between sub-
sidiary companies of a large corpo-
ration. profit-split shows the
consolidated profit of the group which
is attributable to a particular intangi-
ble asset (like trademark). Based
thereupon, a functional analysis of
trademark-related functions per-
formed by the IP holding entity and
the subsidiaries provides a further
allocation of overall trademark prof-
it onto different group entities.
Conclusion
Purchase accounting data is helpful
for gaining a deep understanding of
the transaction values of intangible
assets, and their expected contribu-
tion to future profits of acquired busi-
nesses. Such data helps to reconcile
and redirect the profit-split method,
which has long been an important
method for valuing intangible assets.
With ample purchase accounting data
available as comparables in the public
domain, in-depth case-specific peer
group analyses become possible. This
will not only improve the quality of
the profit-split method itself, but also
make an important contribution to
the overall accuracy of the valuation of
intangibles in general. I
VALUATION STRATEGIES 17PROFIT-SPLIT METHOD July/August 2015
19 Silva, “Letter in Reply to OECD on Transfer
Pricing Comparability Data and Developing
Countries,” 4/11/2014. Accessed at http://
www.oecd.org/ctp/transfer-pricing/royaltystatllc-
conparability-and-developing-countries.pdf.
20 The graph is cut at 40%.

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Valuation of intangibles and trademarks - Bewertung von Immateriellem Vermögen und Marken

  • 1. 4 VALUATION STRATEGIES July/August 20154 VALUATION STRATEGIES The profit-split method remains an essential tool for valuing intangible assets when it is refined with case-specific facts and data, including data that is available from purchase accounting. and Intangibles Valuation of
  • 2. VALUATION STRATEGIES 5July/August 2015 VALUATION STRATEGIES 5 CHRISTOF BINDER AND ANKE NESTLER Trademarks Do Not Miss Out On the Advantages of the Profit-Split Method DespiteUniloc
  • 3. Based on this asset-specific profit, its value can be calculated. Despite the adverse Uniloc decision of the U.S. Court of Appeals for the Federal Cir- cuit in 2011,1 profit split is an impor- tant if not essential element in the valuation of intangibles. In the wake of Uniloc, the method needs not only a vindication, but also a refinement based on case-specific facts and data. Purchase accounting data reported in financial statements can provide both. Profit-Split In a Nutshell The profit-split method is one of the oldest and most frequently applied methods for the valuation of intangi- ble assets. Basically, profit-split attempts to allocate the total profit of a business to the different assets that contribute to it, including the subject intangible. The key element of the prof- it-split method is the derivation of an appropriate or reasonable profit-split percentage based on which a part of the total profit is apportioned to the subject intangible. Overall profit-split Method. Text- books on IP valuation suggest three different variants of the method to arrive at a profit-split percentage.2 According to the overall profit-split method or contribution profit-split method, the combined profits earned by two parties from a transaction (e.g., a licensing transaction) are divided between the two based on some allo- cation principle. Analysis of Comparable Businesses. Under the comparable profit-split method (CPSM), the profitability of comparable businesses with compara- ble IPs is analyzed and applied to the subject business. Comparable profits describe the typical profitability of comparable businesses, including the full cost or expenses for the IP. The subject business calculates its prof- itability before charges for the subject IP, and then adds an IP charge to arrive at a comparable profitability. Residual Profit. The residual profit- split (RSPM) is a stepwise approach to profit allocation of different cate- gories of assets. It starts with routine contributions to assets that are easy to value, i.e. tangibles or intangibles with a typical return rate. Thereafter, the residual profit is allocated to the remaining “special” IP assets of the subject business. Complications. These three methods may sound simple, but in practice they are much more complicated. First, availability of data is limited. It is hard to find financial reporting data for comparable businesses with compara- ble IP, let alone accounting data about their IP. Further, there are no typical return rates for different classes of assets, at most for typical ranges of such return rates. Another restriction of the method is that it is a typical chicken-and-egg phenomenon. The concept of dividing profits among assets is both the crux of the problem and its solution. If the value of the dif- ferent assets and IPs was known, a profit allocation would not be need- ed. And if the profit-split to different assets was known, it would be easy to calculate their values. But it is an equa- tion with two unknown variables. So, valuing IP by comparables or by resid- uals—as the profit-split method sug- gests—is easier said than done. Having said that, how can it be explained that the profit-split method is one of the most frequently applied methods to value IP? Well, this is because valuation practice found two ways out of this dilemma. One is sim- plification, the other sophistication. Simplification. The problem of non- availability of data was circumvented by simplification, or the so-called rules of thumb. As case-specific profit-split data was not available, valuation prac- tice came up with some universal per- centage figures presumed to be typical or average profit-split ratios for intan- 6 VALUATION STRATEGIES July/August 2015 PROFIT-SPLIT METHOD CHRISTOF BINDER, PhD, MBA, is an expert in trademark transactions, licensing, and valuation. He is CEO of Trademark Comparables AG in Switzerland, and MARKABLES, an online database providing comparable data from over 6,500 published purchase valuations of business combinations with a particular focus on trademarks. ANKE NESTLER PhD, MBA, CVA, CLP, is owner of Valnes GmbH, an independent valuation boutique based in Frank- furt, Germany, specializing in the valuation of companies and intangible assets. Prior to establishing Valnes, she was with PricewaterhouseCoopers and Oppenhoff Radler Corporate Finance. Her expertise includes M&A, asset con- tributions, squeeze-outs, tax disputes, arbitration, and succession and legacy issues. A profit-split analysis for a trade- mark or other intangible asset attempts to quantify what share of the profit of a business is attributable to the subject asset.
  • 4. gibles. In its early version, the rule of thumb said that 25% of the profit of a business is attributable to its IP. Dur- ing the course of time, the rule was extended to different ranges extending from 10% to 35%. Further, the profit- split method was often downgraded to a secondary method used to cor- roborate or “sanity check” the results of other primary valuation methods. The good thing with this simplification was that—once the percentage range was commonly accepted—its results were easy to comprehend for unin- volved recipients like auditors, judges, or bankers. More Sophisticated. On the other hand, the profit-split method became much more sophisticated through finan- cial modeling. Financial modeling is a tool to solve a valuation problem with different unknown variables and differ- ent assets to be valued within one and the same model.Typically,such models have some fixed limitations,for example enter- prise value, total profit, and WACC. The model simulates—within such limits— the unknown variables such that the out- come is most plausible. As a mathematical method, financial model- ing is some sort of dynamic program- ming,where different parts of a problem (subproblems) are solved independent- ly and then combined to reach an over- all solution. Computer software greatly fostered the diffusion of financial mod- eling in valuation. However, its com- plexity results in reduced transparency; uninvolved recipients have problems to fully comprehend the results of such val- uations. Therefore, financial modeling is the preferred method for internal use. Profit-Split— From its Origins to Uniloc The profit-split method was pioneered 50 years ago by Robert Goldscheider, one of the early masterminds in tech- nology transfer.3 At the time, Gold- scheider worked as special counsel in technology transfer and licensing issues for Philco Corporation, a consumer electronics company based in Philadel- phia. Outside North America, Philco sold its products in 18 countries through licensing arrangements with local companies. The license agree- ments included various product tech- nologies and patents, trade secrets and know-how, and a set of marketing intangibles including trademarks, pho- tos, drawings, and other copyrighted materials. Further, Philco supplied key components under favorable terms to its licensees. For this bundle of IP and supply rights, each licensee paid a roy- alty rate of 5%. All licensees operated successfully in their local markets. After guiding the business and working with the licensees for two years, Mr. Goldscheider observed that VALUATION STRATEGIES 7PROFIT-SPLIT METHOD July/August 2015 1 Uniloc USA, Inc. v. Microsoft Corp., 632 F.3d 1292 (CA-F.C., 2011). 2 Smith and Parr, Valuation of Intellectual Property and Intangible Assets, 3rd ed. (John Wiley & Sons, 2000) pages 401-403; Llinares and Mert- Beydilli, “How to Determine Trade Marks Royalties,” 32 International Tax Review 12 (December 2006) pages 29-30; Zyla, Fair Value Measurement: Practical Guidance and Implementation, 2nd ed. (John Wiley & Sons, 2012), pages 288-293; Reilly and Schweihs, Guide to Intangible Asset Valuation (AICPA, 2013) pages 311-312. 3 For a detailed description see Goldscheider, “The Classic 25% Rule and The Art of Intellectual Property Licensing,” 46 Les Nouvelles 148 (September 2011), pages 151-153.
  • 5. the pre-tax profitability of each licensee was approximately 20%. Mr. Goldscheider concluded that “5 per- cent was a healthy royalty rate, and I was interested to note that it usually constituted about 25 percent of the profitability ultimately achieved by the various licensees.” This finding was the starting point for Goldscheider to investigate the influence of actual or potential profitability of licensing transactions on the setting of royalty rates. He observed similar patterns from later technology transfer and licensing arrangements. A revenue treatment ratio of 3:1 between the licensee’s and the licensor’s interests proved to be workable in a number of different transactions in unrelated industries. These early empirical observations led toward the formulation of a prag- matic 25:75 baseline working method- ology which generated businesslike results in the negotiation of license agreements, and were the starting point of the profit-split method. The 25% (or any other percentage resulting from a particular royalty rate) is the part of the profit of a business which relates to the IP used by it. Refinement. Later, the method was refined by the “next best alternative” available to the licensee. Starting from the baseline 25% ratio, a serious licensee would also consider the cost of the next best available alternative (e.g., development of the IP in-house, licens- ing other comparable IP, etc.) and com- pare it to the cost (royalty rate) at the 25% baseline profit-split ratio, even- tually resulting in a lower or higher profit-split. Over time, the empirical 25% ratio of the early days was extend- ed to a range from 10% to 35%, based on either net or gross profits, howev- er with its center point always remain- ing at 25%. In the course of time, the method was frequently applied by valuation professionals in various situations for its simplicity, for example: • For the negotiation of royalty rates in IP licensing. • By many courts to corroborate the determination of reasonable roy- alty rates to compensate for IP infringements. • In transfer pricing to check the remaining profitability of a busi- ness after applying arm’s-length royalty rates for the licensed IP. • In financial valuations of IP to cross-check the feasibility of mar- ket comparables with business profitability. • In accounting and auditing for quick checks of IP on the balance sheet. Uniloc. In 2011, the U.S. Court of Appeals for the Federal Circuit brought an abrupt termination to the applica- tion of the 25% profit-split rule of thumb. In its ruling in a patent infringement dispute between Uniloc and Microsoft, it held that: the 25 percent rule of thumb is a fundamentally flawed tool for determining a baseline royalty rate in a hypothetical negotiation. Evi- dence relying on the 25 percent rule of thumb is thus inadmissible under Daubert and the Federal Rules of Evidence, because it fails to tie a reasonable royalty base to the facts of the case at issue.4 The Court of Appeals further explained that this rejection is not meant to be a limit to general valuation principles, but only to the application of flat-rate schemes. This court’s rejection of the 25 per- cent rule of thumb is not intended to limit the application of any of the Georgia-Pacific factors. In par- ticular, factors 1 and 2—looking at royalties paid or received in licenses for the patent in suit or in comparable licenses—and factor 12—looking at the portion of prof- it that may be customarily allowed in the particular business for the use of the invention or similar inventions—remain valid and important factors in the determi- nation of a reasonable royalty rate. However, evidence purporting to apply to these, and any other fac- tors, must be tied to the relevant facts and circumstances of the par- ticular case at issue and the hypo- thetical negotiations that would have taken place in light of those facts and circumstances at the rel- evant time. The rejection of the 25% rule of thumb underscores the importance of using facts of a particular case in cal- culating the reasonable value of IP. Having been widely accepted prior to this court decision, the 25% rule’s rejection is felt across the valuation profession in all different applications of the profit-split method. Valuators are now expected to provide compa- rable profit-split data for their subject case, which almost always does not exist, and the lack of which was one of the reasons to apply the simple but comprehensive “rule of thumb” per- centage ranges. The Limitations of the Classic Profit-Split Method Irrespective of the specific reasons that led to the rejection of the 25% rule in the Uniloc case, there are—and always have been—a number of conceptual limitations to the classic profit-split method: 1. Bundle of rights. The license agree- ments in the original Philco exam- ple comprised a bundle of different IP rights, including patents, knowhow, trademarks, copyrights, and sourcing rights, at a royalty rate of 5% and a profitability of 20%. Each IP individually would have had a lower royalty rate, and a low- er profit-split ratio. Thus, the actu- al profit-split ratio depends on the scope of the licensed rights. 2. No market price. According to the principles of the profit-split method, the licensed IP does not have a typical market price. Its price (royalty rate) is determined by the cost and revenue structure of the licensee and the resulting prof- itability, but not by the price that other licensees might have paid for similar IP, or that the licensor had achieved for similar IP in previous 8 VALUATION STRATEGIES July/August 2015 PROFIT-SPLIT METHOD
  • 6. licensing negotiations. In reality however, the price for IP is some- times what the licensor asks for— irrespective of the profitability of the licensee. 3. No actual profits. The negotiation of royalty rates—and the resulting sharing of profits—is based on prof- it expectations of the licensee, but not on actual profits which might differ from expectations. Often, a license agreement relates to the sub- sequent launch of a new product or business. Depending on the source and the definition of failure, the flop rate of new product launches is between 40% and 80%. Obviously, actual profitability often does not match original expectations. Ex- post, it is likely that numerous unsuccessful licenses were overpaid with excessively high royalty rates. 4. No stable profits. Typically, the launch of a new (licensed) business requires some initial investment and expenses in the early stage. Average profitability varies from the start of a licensed business until the end of its contract term. Thus, the licensee has to consider average expected profitability over the term of the agreement when negotiating the royalty rate. 5. Profit and benefit base. There has always been some degree of dis- agreement on the profit base for the profit-split method. The suggested profit base ranges from fully loaded profit (net profit) over gross profit to marginal or incremental profit. The benefits of a license may be attributed to the products sold that incorporate the IP, or to components or manufacturing processes only. 6. International expansion. The ori- gins of the profit-split method—as described by Robert Goldschei- der—go back to international licensing in an age of import restric- tions, tariffs, and entry barriers. For a company to expand internation- ally there was often no alternative to licensing. The licensed property was granted on an exclusive basis in the licensed territory. Today, licensing is often an approach within the same territory, for example via non-exclu- sive patents or brand extensions. It is not clear how this shift affects profitability and profit-split. 7. Value of IP increasing. As is wide- ly known, intangibles make up for an increasing share of enterprise value. Today, intangibles account for an average of 80% of enterprise value while 50 years ago this per- centage was in the area of 25%. In parallel with the structure of assets and value drivers, the sources of profit changed over time. Profits generated by intangibles increased at the same rate. Today, 80% of profits5 come from intangibles. At the origin of the profit-split con- cept, the 25% of profits generated by IP were allocated to IP. Today, the 25% profit-split rule allows only a fraction of IP-related profits to be allocated to IP. Maybe these—and other—incon- sistencies have been the reason for the extension of the classic profit-split con- cept from the initial 25% ratio to a larger range from 10% to 35%. But the major source of criticism of the prof- VALUATION STRATEGIES 9PROFIT-SPLIT METHOD July/August 2015 4 Uniloc, note 1, supra, page1055. The method needs not only a vindication, but also a refinement.
  • 7. it-split method has always been its missing empirical evidence. The method has never been proven and confirmed—except by Robert Gold- scheider’s description of the Philco case and the fact that it was widely used and accepted. Empirical History There have been a few attempts to pro- vide empirical evidence for the gener- al validity of the classic profit-split rule. The first attempt was made by Robert Goldscheider himself in 2002 to rebut the often stated criticism.6 Gold- scheider and his co-authors tried to compare royalty rates from thousands of actual licensing transactions with expected long-run profit margins of the products that embody the subject IP. However they admit right away that they were unable to undertake a direct comparison of product profit and roy- alty rates because they had no access to such data. In a first step, Goldscheider et al. selected 1,533 license agreements with running royalty rates on sales, grouped them into 15 industries, and identified median royalty rates per industry. In a second step, they identified 347 licensees from the 1,533 agreements that report and disclose their financial statements. Taking the total operating income of these companies, the authors compute an average operating profit margin for the 15 industries over a period of 10 years. Then, they com- pare the 15 median industry royalty rates with the 15 average profit margins and find an average ratio of 27%.7 They conclude that the empirical analysis provides “some support” for the use of the 25% profit-split rule, but they also admit “that there is quite a variation in results for specific industries,” ranging from an 8.5% split for the semicon- ductor industry to an 80% split in the automotive industry (see Exhibit 1).8 Likely, these variations would be even larger at the level of the 347 individual companies. The empirical test shows that on average the 25% split ratio is a good overall approximation, but the statistical variance is too high to explain the split ratios at an industry let alone company or licensed business level. Second Study. A second attempt to analyze the relation between prof- itability and royalty rates was pub- lished by Kemmerer and Lu in 2008.9 They used average industry royalty rates for 14 industries compiled from 3,015 license agreements, and prof- itability from a fully separate sample of 3,887 companies mapped into the same 14 industries.As profitability measures they test operating profit, EBIT, and gross profit. Interestingly, the average royalty rate in their sample is 7.0%, which is substantially higher than the median rate of only 4.3% observed by Goldscheider et al. On average they find that royalty rates account for 15% of gross, 41% of EBITDA, and 53% of EBIT margins. They confirm earlier findings that these overall ratios vary at industry level. Finally, they provide some limited support for the validity of the 25% rule based on operating prof- its assuming a (hypothetical) forced linear fitting between royalty rates and operating margins. In a specification of his first study, Lu conducted a pro forma analysis based on corrected “pre-royalty” prof- itability data.10 In other words, he added the royalty rate on top of the profit margin, thereby assuming that the licensee considers the profitabil- ity of the licensed business before pay- ing royalties for the IP and then applies the profit-split on this (high- er) margin. Lu now finds an average 13% profit-split based on gross prof- it, 26% on EBITDA and 32% on EBIT. Based on these results, Lu concludes “The 25% rule still rules” and sug- gests starting royalty negotiations with 25% of EBITDA margin or 33% of EBIT margin. What he does not say 10 VALUATION STRATEGIES July/August 2015 PROFIT-SPLIT METHOD EXHIBIT 1 Profit-Split by Industry Source: Goldscheider, Jarosz, Mulhern 2002 automotive chemicals computers consumer goods electronics energyfood internet machine, tools pharma, biotech semiconductors software telecom 0% 5% 10% 15% 20% 25% 30% 35% 2% 3% 4% 5% 6% 7% 8% avgoperatingprofitmargin mean royalty rate IP Profit Split by Industries - Goldscheider Study 2002 50% split line 25% split line 15% split line healthcare
  • 8. however is that on this pre-royalty assumption Goldscheider’s classic rule would transform from 25% down to 20%.11 Moreover, he does not address the large bandwidth of the individual or industry value around the overall average. Evidence Not Provided. None of the empirical tests could provide evidence for the validity of the 25% rule.12 The difficulty with these studies is that it was not possible to analyze the royal- ty rate and the profitability of a licensed business from the same set of data. Typically, researchers ana- lyzed a set of royalty rates, and a sep- arate set of profit rates of other busi- nesses in the same industry. There is some evidence that the overall average profit-split might well be in the area of 25%, depending on the profit base used. However, the variance from that average can be very large at the level of individual cases, thus the average being eventually meaningless in a spe- cific case. The rule might still be used as some sort of a rule if the frequen- cy distribution of the individual val- ues around the mean value was known. This not being the case, the rule is not a rule but an average val- ue with little relevance for a subject case. Insofar, the Court of Appeals was correct to require the considera- tion of relevant facts and circum- stances of the case at issue. Does Profit Explain IP Value At All? Very broadly speaking, valuation is strongly oriented towards market prices or other concepts that come close to it. If market prices do not exist for an asset—which is typical for any IP asset—the next best principles are fair value or arm’s-length. Both prin- ciples try to reconstruct a hypotheti- cal but realistic transaction between unrelated parties. Now, how does profit-split fit into these principles? According to profit- split, the price of an IP asset depends on the profitability of the business that uses this IP. If the profitability of the business is low, a hypothetical independent buyer would pay a low price for it, and vice versa. However in reality, the value of the IP for the buy- er might depend less on the prof- itability of the seller than on the benefit of the IP for the buyer. This raises the question if the value of IP depends on business profitability, and if this is a discrepancy between prof- it-split and other valuation methods which are based on market transac- tions? Interestingly, the valuation pro- fession never discussed the question if there is a significant causality between business profitability and IP value. A clear yes to this question is however a prerequisite for the future application of the profit-split method—at whatever percentage ratio. To have a closer look at this question, we have to change perspec- tive. The question to ask is not if prof- itability explains the value of IP, but rather, if IP contributes to profitabil- ity, and if, so how much? Tangible Assets. If we looked for a moment at tangible assets only— PP&E, inventory, receivables—they are not profitable as such. The business must generate enough profit to pay for their depreciation. If the business want- ed to sell them, it would typically earn their book value, without making a profit or a loss. If it is able to make profit on tangible assets, it is either because of speculation or these assets are currently in short supply. Thus, all tangibles sitting on the balance sheet generate the profit they have to: their depreciation and/or their cost of finance. Let us call this the base prof- it on book value. VALUATION STRATEGIES 11PROFIT-SPLIT METHOD July/August 2015 5 Or more, depending on the required return rates on tangibles and intangibles. 6 Goldscheider, Jarosz, and Mulhern, “Use Of The 25 Per Cent Rule in Valuing IP,” 37 Les Nouvelles 123 (December 2002). 7 Using data from successful licensees only. 8 This range does not include the media and enter- tainment and the internet industry. Here, long- term industry profitability is far below median royalty rates, resulting in flawed ratios. 9 Kemmerer and Lu, “Profitability and Royalty Rates Across Industries: Some Preliminary Evidence,” 8 J. of the Academy of Business and Economics (March 2008). 10 Lu, “The 25% Rule Still Rules—New Evidence from Pro Forma Analysis in Royalty Rates,” 46 Les Nouvelles (March 2011). Valuators are expected to provide comparable data which almost always does not exist.
  • 9. Unaccounted Intangibles. Any addi- tional profit on top of such base prof- it would be for assets that are not yet on the balance sheet—(unaccounted) intangibles. The value of these intan- gible assets would be the higher the more profitable the business. This is a very simple logic. The only difficulty is that we can’t see the value of these intangibles in the books. They are not accounted for—unless the business is acquired. A next question is—what would happen if the profitability and the value of the business increased? From which “improved” assets would the increased profitability come from? To understand these connections better, we have a closer look at the consec- utive purchase accounting of two companies that were acquired two times within a few years, and analyze how different assets developed (see Exhibit 2).13 Both cases are quite different in their valuation multiples. EPAX has a high valuation in a high-margin and growth business; Cellu is a commod- ity business with low margins and large machinery. In both cases, the first acquirer created significant val- ue before he resold the company. Vis- ibly, both invested massively in tangible assets, thereby restructuring the business and increasing capacity, revenues and margins. But enterprise value grew by much more than only by these visible and accountable investments in tangibles. Intangible assets increased as well. Higher qual- ity, more efficient processes, and increased expenses for R&D and mar- keting might all have contributed to the increase in intangibles. Whatever it was, the two examples show that higher profitability typically results in higher valued intangibles. Data Availability. Data availability is limited for such time-series analysis. Only a few such cases are known and reported in sufficient details. Howev- er, single values can be analyzed in large data samples from purchase accounting databases, like MARK- ABLES.14 Linear regression analysis illustrates how the asset structure of businesses changes with increasing profitability. The share of tangibles assets within enterprise value decreas- es with increasing profitability, while the share of goodwill increases. Iden- tifiable and separable intangible assets behave steadily, as illustrated in Exhib- it 3.15 The flat line for intangibles shows that the value of intangibles behaves proportionately with profitability. In other words—if profitability doubles, the value of intangibles will—on aver- age—also double. Of course—this rela- tion might be different for a particular business. But as an overall relation- ship, there is causality between prof- itability and the value of intangibles. This may sound simple and clear-cut, but it is an important if not vital find- ing for the future of the profit-split method. If this causality did not exist, profit-split would be doomed to die, not only as a 25% flat rule, but alto- gether. Applying Profit-Split Based on Purchase Accounting Data As stated earlier, one major problem of the classic profit-split method is data availability. Except for the few Philco licensees cited by Robert Gold- scheider, profit-split could never be tested from a concise set of data. It was simply not possible to observe the value of the IP (its royalty rate) and the profit for the same IP, because either one of the two was unknown. A license agreement shows a royalty rate, but not the profitability of the 12 VALUATION STRATEGIES July/August 2015 PROFIT-SPLIT METHOD 11 25/100 versus 25/(100+25). 12 A detailed discussion of the empirical tests was published by Kidder and O’Brien, “Simply Wrong: The 25% Rule Examined,” 46 Les Nouvelles 263 (December 2011). 13 Norwegian EPAX AS, a supplier of Omega-3 fish oils, was acquired in 2007 by Austevoll Seafood ASA, and then in 2013 by FMC Corporation. Cellu Tissu is a manufacturer of specialty tissue paper for use in personal hygiene products. Cellu Tissu was acquired in 2006 by Weston Presidio (an investment firm), and in 2010 by Clearwater Paper. 14 MARKABLES is a database containing data from over 6,500 PPAs, with a particular focus on trade- mark and brand assets. www.markables.net 15 The three lines add up to more than 100% due to non-interest-bearing liabilities. Such liabilities decrease with increasing profitability. Meaningful profit-split data is available from purchase accounting.
  • 10. licensed business, even not its expect- ed profitability. Even more, a licensee would be ill-advised to reveal his profit expectations to the licensor during license negotiations. And years later, the profit and loss statement of a licensed business no longer tells what royalty rate the licensee would have accepted, had he known its lat- er profitability. Data from Purchase Accounting. However, meaningful profit-split data is available in substantial numbers and detail from purchase account- ing. Possibly, our view was clouded due to the approach of splitting prof- it between two separate parties we became so much used to. Purchase accounting, which is also frequently referred to as acquisition account- ing, is the process of classifying, valu- ing, and accounting for all of the assets and liabilities that are includ- ed in the acquisition of a business. This process is rather standard for the tangibles assets and the liabili- ties that are already in the books of the acquired business. The difference between the book value of the acquired assets and liabilities and the purchase consideration is then allo- cated to the various intangible assets, and to goodwill. Technically, the purchase consider- ation paid for the acquired business (or the enterprise value including debt) is the present value of all returns it is expected to generate in the future. The valuation of the intangible assets is an allocation of these expected future returns to particular assets. And the present value of any intangible asset at the date of the acquisition relates to its share of total future returns that are expected from that business. This reads like the nearly perfect profit-split for intangibles, and in fact it comes close to it. The results from purchase accounting— purchase price alloca- tions on business combinations—are reported manifold in the financial statements of public companies. Exhib- it 4 illustrates how to compute profit- split data from the results of a purchase price allocation. In this particular busi- ness, 38% of future profits are expect- ed to come from (existing) customer relations, 17% from product technol- ogy and 4% from trade names. VALUATION STRATEGIES 13PROFIT-SPLIT METHOD July/August 2015 EXHIBIT 2 Asset Development over Time Source: MARKABLES.net Development of Assets Over Time – Purchase Accounting EPAX AS Cellu Tissu Holdings, Inc. US$ million 2007 2013 2006 2010 revenues 40 75 1.9x 329 511 1.6x enterprise value 98 340 3.5x 208 534 2.0x sales multiple 2.5x 4.5x 1.9x 0.6x 1.0x 1.7x tangible assets 40 212 5.2x 143 406 2.8x intangible assets 91 215 2.4x 70 286 4.1x debt 42 0 - 163 287 1.8x EXHIBIT 3 Value of Identifiable Intangible Assets 4,550 share deals between 2004 and 2014 Source: markables.net profitability enterprise value/revenues 0% 20% 40% 60% 80% 100% 0x 1x 2x 3x 4x 5x 6x 7x 8x 9x 10x percentofenterprisevalue tangibles intangibles goodwill y = -0,0532x + 0,972 y = 0,0133x + 0,4608 y = -0,0025x + 0,3816 Profitability and Asset Value Linear Regressions
  • 11. These data applied to the more clas- sic profit-split methods mean that Life Technologies would be willing to pay 21.6% of his profits as a royalty to license-in product technology, trade- marks and in-process research.16 Moreover, Life Technologies would likely not pay a royalty for customer relations because these are typically owned and cannot be licensed-in. The use of such data is compellingly convincing. Still, the following limita- tions should be noted: 1. Useful life. Intangibles assets have different useful lives. For an intan- gible asset with a short useful life, its profits are expected to be generat- ed faster, and vice versa for an intan- gible asset with very long or indefinite life. A 10% profit-split with a useful life of ten years means a higher profit margin (for the next ten years) than a 10% profit-split over 20 years. 2. Fair value. The value of an intangi- ble asset as stated in the purchase price allocation (PPA) is its fair val- ue, not its market value or market price.17 It is thus the result of a fair value calculation. Still, it comes close to the willingness of the acquirer to pay for this particular asset, based on a real transaction of ownership of the subject business in total. Based on this real transaction, the fair values for particular intan- gibles can serve as a meaningful approximation for “market” prices paid for such intangibles. 3. Different use. The data represents the view of the acquirer, not the pre- vious owner. If the acquirer intends to restructure the business, or if he has only little use for a particular 14 VALUATION STRATEGIES July/August 2015 PROFIT-SPLIT METHOD EXHIBIT 5 Profit-Split Analysis 0 50 100 150 200 250 300 350 2.5% 7.5% 12.5% 17.5% 22.5% 27.5% 32.5% 37.5% 42.5% 47.5% 52.5% 57.5% 62.5% 67.5% 72.5% 77.5% 82.5% 87.5% 92.5% 97.5% occurence % of enterprise value Profit Split of Licensable Intangibles in % of enterprise value 25% quartile 9.0% median 18.2% 75% quartile 32.1% mean 24.4% 4,550 share deals between 2004 and 2014; identifiable intangible assets not including customer relations Source: markables.net 75 quartile 25 quartile median EXHIBIT 4 Computation of Profit-Split Data Useful life (years) Life Technologies(In millions) Purchase Price Net Assets Acquired Cash paid $ 13,487.3 2,279.5 7,167.0 $ 15,303.8 2,626.9 5,883.0 16 748.1 619.1 246.7 58.4 $ 15,303.8 $ 1,755.5 (463.0) (3,800.9) Current assets Property, plant and equipment Definite-lived intangible assets: Indefinite-lived intangible assets: Goodwill Other assets Liabilities assumed Customer relationships Product technology Trade names and other In-process research and development Debt assumed Cash acquired 11 9 Profit split 100.0% 38.4% 17.2% 4.0% 0.4% 46.8% Acquisition of Life Technologies Corp. by Thermo Fisher Scientific Inc. Purchase Price Allocation as of February 3, 2014 Source: Thermo Fisher Scientific Inc., Form 10-K for the Period Ending 12/31/2014; profit split calculation by authors
  • 12. intangible, he might allocate only little value to it, while this particu- lar asset had a higher value to the previous owner, and vice versa. 4. Liabilities involved. In the PPA illus- trated in Exhibit 4, the acquisition was a share deal involving non- interest-bearing liabilities of $3.8 billion. These interest-free liabili- ties reduce the 100% base. Or, there are assets in the same amount that do not need to generate returns. Often, this is covered by netting of short-term working capital. If the acquisition is however performed as an asset deal, these liabilities are often not part of it, and the 100% base is higher. In such cases, prof- it-split data taken from asset deals must be adjusted by liabilities that are typical for the subject industry. 5. Tax. The value of intangibles and goodwill can vary for its tax deductibility. Tax deductibility results in a higher value and in an interest-free tax liability of the same amount, and thus in a higher prof- it-split percentage. Typically, this information can be found with the PPA. In the case illustrated in Exhib- it 4, neither intangibles nor goodwill are deductible for tax purposes. Benefits. On the other hand, the ben- efits of profit-split based on purchase accounting data are quite obvious: 1. Data availability. Numerous data are available in the public domain and fully open to scrutiny. 2. Data quality. Data are calculated according to national and interna- tional accounting standards. More- over, results of valuations are cross-checked relative to each oth- er and against the 100% threshold of purchase consideration effectively paid. Finally, data are audited by CPAs. 3. Transaction-based. Data result from real market transactions on M&A markets, where market conditions are more“perfect” than on licensing markets. Prices paid are based on commonly accepted valuation mul- tiples and on thorough due dili- gence. 4. Established businesses. Businesses covered are fully established and reliably assessable. This compares to licensed businesses which are new and risky at the effective date of the license agreement, and often fail to succeed. 5. Profits from long-term ownership. Profitability is based on expected long-term, fully loaded profits to acquire and own the intangible. This is a more realistic concept than profit under a rather short-term license agreement. 6. Integrated data. Last but not least, the method is based on integrated data. Both price (value) of intangi- bles and profit-split relate to one and the same business. A Reconciliation of the Classic Profit-Split Method Using data from purchase accounting as comparables for profit-split valua- tion is a new approach. Now, it would be interesting to see how such data compare to the earlier attempts to ver- ify the validity of the classic profit- split method. The following analysis is based on data taken from the MARKABLES database.18 The profit- split for the sum of licensable intangi- bles was analyzed as percent of enterprise value. Licensable intangi- bles were defined as identifiable intan- gibles not including such intangibles that are typically not licensable (e.g., customer relations, customer contracts, or backlog). The findings are illus- trated in Exhibit 5. VALUATION STRATEGIES 15PROFIT-SPLIT METHOD July/August 2015 16 17.2% + 4.0% + 0.4%. 17 For a comprehensive and detailed overview of fair value accounting, see Zyla, note 2, supra. 18 The MARKABLES database contains data from over 6,500 PPAs, with a particular focus on trade- mark and brand assets (www.markables.net). Business reality is far too diverse to be mapped with averages or narrow ranges.
  • 13. Support for Goldscheider. Interest- ingly, the findings provide strong evi- dence for Robert Goldscheider’s early observations. The mean profit-split of licensable intangibles is 24.4%, thus very close to Goldscheider’s 25% observation. This finding is good for both Goldscheider, whose classic rule receives some sort of reconciliation, and for the purchase accounting-based method which shows mean values very similar to those found in the earlier research performed by Goldscheider et al. It must be noted that these find- ings relate to the sum of all (hypo- thetically) licensable intangibles a company owns or uses. But beyond that 25% mean value, the findings also show the large band- width of individual data. 50% of all cases are situated somewhere between a 9% and a 32% profit-split. The oth- er 50% of the cases have profit ratios even below or above these percentages. Obviously, there exist many business- es that need very little if any licens- able intangibles to operate, and there are others whose value structure is dri- ven to a very large extent by such intangibles. This is exactly what the Court of Appeals found and ruled in the Uniloc decision. Business reality is far too diverse to be mapped with aver- ages or narrow ranges. Trademark Profit-Split profit-split in the original Philco analy- sis—and in many cases thereafter— was based on a bundle of different IP rights, including patents, know-how; trade names, and copyrights. This bundling seems to be usual practice in IP licensing. Out of 13,078 license agreements with unredacted running royalty rates listed in the RoyaltySource database, 83% comprise bundles of various IP rights, and no more than 13% are pure play license agreements covering one specific IP only.19 How- ever, IP valuation and litigation is often about one particular IP; the bundle is more typical in transfer pricing for subsidiaries. The following discussion takes a closer look at the valuation of one particular intangible asset, name- ly trademarks (or brands). Exhibit 6 illustrates the frequency distribution of trademark profit-split which—being a part of the total licens- able asset bundle—must necessarily be lower (further left) than the distri- bution for all intangibles in Exhibit 5. The analysis shows that trademarks (or brands) account for an average of 13.1% of enterprise value or future profits. The median of the distribution is 6.6%.With regard to the classic prof- it-split rule of 25%, this would be far too high to be applied as a rule of thumb on a pure play trademark alone. Again, the bandwidth over all different trademarks in the sample is very high, ranging from close to zero up to over 100%.20 It is immediately clear that a brand of Swiss luxury watches must make a much higher contribution to profit than the trade name of an oil well drilling business in Idaho. Or in the case of a natural cat litter business, the value of the brand accounts for near- ly 100% of enterprise value; the busi- ness sources the packaged products from a quarry mill nearby; it has no own production or technology, and no relations to end customers. Almost all of its enterprise value is driven by the brand. As the Court of Appeals con- cluded in Uniloc,“evidence … must be 16 VALUATION STRATEGIES July/August 2015 PROFIT-SPLIT METHOD EXHIBIT 7 Trademark Profit-Split Analysis of Watch Businesses 0% 5% 10% 15% 20% 25% - trademark profit split and royalty rates - 0% 20% 40% 60% 80% 100% 120% 1 2 3 4 5 6 7 8 9 10 11 Watch businesses Watch businesses - trademark profit split (% of enterprise value) - luxury watches commercial watches distressed businesses Source: markables.net R = 0.85112 75 %ile25 %ile median EXHIBIT 6 Frequency Distribution of Trademark Profit-Split 0 50 100 150 200 250 300 350 400 450 1% 3% 5% 7% 9% 11% 13% 15% 17% 19% 21% 23% 25% 27% 29% 31% 33% 35% 37% 39% Trademark Profit Split in % of enterprise value 0 50 100 150 200 250 300 350 400 450 1% 3% 5% 7% 9% 11% 13% 15% 17% 19% 21% 23% 25% 27% 29% 31% 33% 35% 37% 39% occurence % of enterprise value 25% quartile median 75% quartile mean 4,550 share deals between 2004 and 2014 Source: markables.net 75 quartile 25 quartile median 2.5% 6.6% 16.5% 13.1%
  • 14. tied to the relevant facts and circum- stances of the particular case at issue.” To further illustrate this, a peer group analysis of trademark profit- split in the watch-making business based on purchase accounting data was performed (see Exhibit 7).Watches are generally known to be highly brand driven and to generate attractive prof- it margins. The peer group includes eleven different watch brands of which six are based in Switzerland, four in the U.S., and one in Germany. Obviously, the profit-split ratios for the eleven watch businesses show a wide range from 18% to 102% (Exhib- it 7, left part). The 25-75 quartiles range from 22% to 60%, the median is 25%. Towards the high end of the dis- tribution, the curve shows a steep increase. This particular peer group— as any other peer group—illustrates that industry or category specific prof- it-split ratios do not exist. Too differ- ent are the value driver and profitability structures at a company level, even within the same industry. Further analysis reveals however a linear relation between trademark profit-split and royalty rates (Exhib- it 7, right part). The higher the prof- it-split ratio, the higher the royalty rate which the trademark generates on revenues. When looking closer at the eleven watch businesses, a clear segmentation appears. Luxury watch- es during normal course of business show both high profit-split ratios and high royalty rates. Commercial or fashion watches show medium roy- alty rates and profit-split ratios. The third segment comprises watch busi- nesses in a turnaround situation. Considering the retail prices of the watches in that segment, they belong to the premium/luxury segment; con- sidering their weak profitability how- ever, their accounts leave no room for high trademark values. Thus, trade- mark profit-split becomes a major determinant of trademark value in connection with other determinants like royalty rate and overall profit margins. Similar trademark analyses can be performed for most categories or industries. Transfer Pricing Application. The application of such profit-split analy- ses is not limited to the valuation of intangible assets; it is also helpful in transfer pricing issues between sub- sidiary companies of a large corpo- ration. profit-split shows the consolidated profit of the group which is attributable to a particular intangi- ble asset (like trademark). Based thereupon, a functional analysis of trademark-related functions per- formed by the IP holding entity and the subsidiaries provides a further allocation of overall trademark prof- it onto different group entities. Conclusion Purchase accounting data is helpful for gaining a deep understanding of the transaction values of intangible assets, and their expected contribu- tion to future profits of acquired busi- nesses. Such data helps to reconcile and redirect the profit-split method, which has long been an important method for valuing intangible assets. With ample purchase accounting data available as comparables in the public domain, in-depth case-specific peer group analyses become possible. This will not only improve the quality of the profit-split method itself, but also make an important contribution to the overall accuracy of the valuation of intangibles in general. I VALUATION STRATEGIES 17PROFIT-SPLIT METHOD July/August 2015 19 Silva, “Letter in Reply to OECD on Transfer Pricing Comparability Data and Developing Countries,” 4/11/2014. Accessed at http:// www.oecd.org/ctp/transfer-pricing/royaltystatllc- conparability-and-developing-countries.pdf. 20 The graph is cut at 40%.